Wednesday, November 28, 2012

Death of a Prediction Market

A couple of days ago Intrade announced that it was closing its doors to US residents in response to "legal and regulatory pressures." American traders are required to close out their positions by December 23rd, and withdraw all remaining funds by the 31st. Liquidity has dried up and spreads have widened considerably since the announcement. There have even been sharp price movements in some markets with no significant news, reflecting a skewed geographic distribution of beliefs regarding the likelihood of certain events.

The company will survive, maybe even thrive, as it adds new contracts on sporting events to cater to it's customers in Europe and elsewhere. But the contracts that made it famous - the US election markets - will dwindle and perhaps even disappear. Even a cursory glance at the Intrade forum reveals the importance of its US customers to these markets. Individuals from all corners of the country with views spanning the ideological spectrum, and detailed knowledge of their own political subcultures, will no longer be able to participate. There will be a rebirth at some point, perhaps launched by a new entrant with regulatory approval, but for the moment there is a vacuum in a once vibrant corner of the political landscape.

The closure was precipitated by a CFTC suit alleging that the company "solicited and permitted" US persons to buy and sell commodity options without being a registered exchange, in violation of US law. But it appears that hostility to prediction markets among regulators runs deeper than that, since an attempt by Nadex to register and offer binary options contracts on political events was previously denied on the grounds that "the contracts involve gaming and are contrary to the public interest."

The CFTC did not specify why exactly such markets are contrary to the public interest, and it's worth asking what the basis for such a position might be.

I can think of two reasons, neither of which are particularly compelling in this context. First, all traders have to post margin equal to their worst-case loss, even though in the aggregate the payouts from all bets will net to zero. This means that cash is tied up as collateral to support speculative bets, when it could be put to more productive uses such as the financing of investment. This is a capital diversion effect. Second, even though the exchange claims to keep this margin in segregated accounts, separate from company funds, there is always the possibility that its deposits are not fully insured and could be lost if the Irish banking system were to collapse. These losses would ultimately be incurred by traders, who would then have very limited legal recourse.

These arguments are not without merit. But if one really wanted to restrain the diversion of capital to support speculative positions, Intrade is hardly the place to start. Vastly greater amounts of collateral are tied up in support of speculation using interest rate and currency swaps, credit derivatives, options, and futures contracts. It is true that such contracts can also be used to reduce risk exposures, but so can prediction markets. Furthermore, the volume of derivatives trading has far exceeded levels needed to accommodate hedging demands for at least a decade. Sheila Bair recently described synthetic CDOs and naked CDSs as "a game of fantasy football" with unbounded stakes. In comparison with the scale of betting in licensed exchanges and over-the-counter swaps, Intrade's capital diversion effect is truly negligible.

The second argument, concerning the segregation and safety of funds, is more relevant. Even if the exchange maintains a strict separation of company funds from posted margin despite the absence of regulatory oversight, there's always the possibility that its deposits in the Irish banking system are not fully secure. Sophisticated traders are well aware of this risk, which could be substantially mitigated (though clearly not eliminated entirely) by licensing and regulation.

In judging the wisdom of the CFTC action, it's also worth considering the benefits that prediction markets provide. Attempts at manipulation notwithstanding, it's hard to imagine a major election in the US without the prognostications of pundits and pollsters being measured against the markets. They have become part of the fabric of social interaction and conversation around political events.

But from my perspective, the primary benefit of prediction markets has been pedagogical. I've used them frequently in my financial economics course to illustrate basic concepts such as expected return, risk, skewness, margin, short sales, trading algorithms, and arbitrage. Intrade has been generous with its data, allowing public access to order books, charts and spreadsheets, and this information has found its way over the years into slides, problem sets, and exams. All of this could have been done using other sources and methods, but the canonical prediction market contract - a binary option on a visible and familiar public event - is particularly well suited for these purposes.

The first time I wrote about prediction markets on this blog was back in August 2003. Intrade didn't exist at the time but its precursor, Tradesports, was up and running, and the Iowa Electronic Markets had already been active for over a decade. Over the nine years since that early post, I've used data from prediction markets to discuss arbitrage, overreaction, manipulation, self-fulfilling prophecies, algorithmic trading, and the interpretation of prices and order books. Many of these posts have been about broader issues that also arise in more economically significant markets, but can be seen with great clarity in the Intrade laboratory.

It seems to me that the energies of regulators would be better directed elsewhere, at real and significant threats to financial stability, instead of being targeted at a small scale exchange which has become culturally significant and serves an educational purpose. The CFTC action just reinforces the perception that financial sector enforcement in the United States is a random, arbitrary process and that regulators keep on missing the wood for the trees.

12 comments:

Given that this is a democratization of previously highly (in both senses) controlled financial markets, it makes sense that regulation can be equally serious.

The questions you raise fall back on the "call money" problem of the 1930s. Since then, traders margin up with a settlement house marked to market.

Etc. Sounds like what Intrade should have been doing.

A propos, isn't it possible that one reason the markets are so popular with your courses is their arithmetic variability? In thin markets lots of features are more visible.

A double propos: have you any thoughts or measures regarding _efficiency_ in these markets.

En pointe, perhaps you are shedding crocodile tears like Dr. Bell after Jack the Ripper left town. Or, you are dissuading us as a cabal of financiers including like Sheldon Abramson and Donald Trump is setting up a U.S. intrade. Sort of like the NYSE, to Intrade's Amex?

Ronald, marking to market would not work in Intrade because many contracts have a positive probability of immediate expiry. For instance, a coup in Syria would result in all three Assad contracts expiring at 100 right away, and the exchange needs to ensure that those with short positions can pay up. For the election contracts, scandal, illness or death could have had such effects. Margin has to cover worst case loss from the outset.

The markets are popular with students because they can easily compare prices with their own subjective probabilities of public events, and think about whether a contract is fairly priced. It takes a lot of research to figure this out for stocks an bonds. They can compute risk and return easily since there are only two outcomes. And they can understand arbitrage by comparing complementary contracts or thinking about replication of portfolios using different sets of contracts. It's not the thinness of the markets that matters here it's the simplicity of the binary option and its relation to familiar events.

Regarding efficiency, an important issue that arises with prediction markets is the possibility of positive feedback between prices and objective probabilities (discussed here for instance). This makes manipulation potentially profitable and efficiency hard to define.

Thanks for this very interesting discussion of prediction markets. I find the possibility of positive feedback between prices and objective probabilities, and the resulting profits from manipulation quite interesting. It has been also a point made by researchers working on commodity markets that any large speculative position taking through index investment can signal that prices are likely to rise (or fall) in the future, which can change the objective probabilities, and thus create profit opportunities for very large index investors. And there are also prediction markets for commodities like gold or oil. So one question I have is do you think that prediction markets in commodities do help price discovery, and by doing so, improves public benefit? Or, do you think that it is more difficult to catch manipulation in these markets, which creates profit for investment bankers and losses for consumers of commodities that have inelastic demand for them?

Bilge, in commodity markets the feedback from prices to fundamentals is usually negative: higher prices induce lower demand and increased supply, which should lower future prices. Short-run manipulation and bubbles are still possible but can't really be sustained for very long.

Credit markets are different, a sharp rise in the cost of borrowing can make a debtor more likely to default, thus justifying the rise in the cost of borrowing. Multiple equilibria are possible here, which makes manipulation (or self-fulling bear raids as they are sometimes called) potentially profitable even in the long-run.

Prediction markets are like credit markets in this respect. Inflating the possibility of victory can cause fundraising and morale to rise, thus increasing the objective likelihood of victory. This effect is discussed in more detail here.

Rajiv, thanks so much for your comment. I agree with you that usually in commodity markets higher prices lead to lower demand and increased supply, thus correcting the short-run deviation. Recently the financialization of commodity futures markets raised the question of whether there can be positive feedback affects running from futures prices to spot prices. For example, Xiong and Sockin argue that if "industrial producers across the world use futures prices of oil and copper as signals of the strength of the global economy, an increase in the futures prices, even if driven bynon-fundamental factors, may lead industrial producers to increase, rather than decrease, commodity demand, which in turn can cause spot prices of these commodities to rise. Such feedback effects thus motivate a re-examination of the aforementioned economic arguments." (http://www.princeton.edu/~wxiong/papers/feedback.pdf). There has been also Keynesian arguments, including Ghosh, Heintz and Pollin, who wrote: "One indicator that futures prices are influencing spot prices is a build-up of inventories when bothspot prices and futures prices are increasing. The reasoning is straightforward: if suppliers in spot markets expect prices to increase in the future, they may withhold their products from the market in order to profit from higher prices in the future (the amount withheld depending on storage costs and discount rates). The withdrawal of supply then pushes up prices in spot markets. Note that a build-up of inventories when spot prices are increasing must be driven by expectations, and not fundamentalshifts in supply and demand. The explanation for increasing inventories during times of rising prices is that prices are expected to be even higher in the future." (http://www.peri.umass.edu/fileadmin/pdf/working_papers/working_papers_251-300/WP269.pdf)These are just some examples. So I see a similarity to the effects of speculative manipulation in prediction markets and speculative trading in commodity markets, although they work through different channels, as you pointed out.

Thanks Bilge, these are interesting effects. There's a tight link between sport and futures prices in any case through the spot-futures parity theorem, violation of which implies an arbitrage opportunity. But the effects you have in mind can lead to bubbles and excess volatility in spot and futures markets simultaneously.

I still think that credit default and prediction markets are different because speculation can have permanent effects by affecting which of multiple equilibria are selected.

Thanks for the interesting discussion. I agree with your last point. The channels through which speculation changes equilibrium outcomes differ according to the markets in question, and the effects may be temporary or permanent again according to the market.

By the way, will you be around for the Spring semester soon? Would be wonderful to catch up with you!